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Monday, December 14, 2015

So it is finally time for lift off. The Fed is poised to raise short-term interest rates over the next few days after seven long years of ZIRP. Exciting as this development may be, it is important to keep in mind that the guiding principle behind the Fed's decisions during this time has not suddenly changed. This principle says that no matter what happens--whether it be ZIRP, QE, forward guidance, the changing winds of fiscal policy, or the normalization of monetary policy--the Fed must always act in a manner to keep core PCE inflation within a 1-2 percent inflation corridor.

Yes, even though the Fed has an official 2 percent inflation target revealed preferences indicate the real force shaping Fed policy has been a 1-2 percent inflation target corridor over the past seven years. Once you understand this point all other Fed mysteries begin to clear up. For example, why did the Fed sterilize its lending to banks between December 2007 and October 2008? Or, why did it introduce IOR just as the markets were imploding or make the asset purchases under QE temporary? The answer is that it did not want rapid growth in nominal spending--even though it was sorely needed--for fear of pushing inflation too high. The Fed, in other words, was willing to sacrifice the economy at the altar of the inflation target corridor. This framework is likely to continue going forward.

But don't take my word for it. Let's look to the data and let the FOMC's revealed preferences speak for themselves.

Consider first the central tendency consensus forecasts of core PCE inflation by FOMC members. The figures below show these
forecasts for the current year, one-year ahead, and two-years ahead horizons. A clear pattern emerges from these figures as you
expand the forecast horizon: 2 percent becomes a upper bound. FOMC officials, therefore, have been consistently looking at an
upper bound of 2 percent for core PCE inflation. If we add to this fact that the FOMC has meaningful influence on inflation
several years out, then these revealed preference are saying Fed officials actually want
and expect to get an inflation upper bound of 2 percent. This inflation corridor is a choice.

Now consider the actual performance of core PCE inflation since the crisis started. This is where the 1 percent lower bound on the corridor becomes evident. The Fed seems ready to pull the monetary trigger if core inflation drifts too close to this lower bound. Currently, core inflation has stabilized around 1.3 percent but should it start falling again I would not be surprised to see the Fed getting trigger happy once again.

These revealed preferences of the Fed have begun to affect the public's long-term inflation expectations.The figure below shows the annual average inflation forecast over the next 10 years from the Survey of Professional Forecasters. I would not call these forecasts unanchored, but they are gradually drifting down. In the past we worried about expectations becoming unanchored as inflation expectations drifted upward. Now it seems they are drifting in the other direction, though presumably anchored by a lower bound.

The low inflation environment of the past few years seems entirely in line with the revealed preferences of FOMC officials. There is nothing mysterious about it. Fed officials are getting what they want. Unfortunately, aiming for a inflation corridor of 1-2 percent does guarantee macroeconomic stability. This inflation target range could be either be too tight or too easy depending on the state of the economy. It would be far better for the Fed to simply stabilize the growth path of aggregate spending. Until then, expect the Fed's decisions to be guided by the inflation target corridor.

P.S. See Russ Robert's interview of George Selgin on EconTalk for an interesting discussion where some of the Fed's mysterious actions over the past seven years are discussed.

Update: Janet Yellen, made this point in the press conference following the December 2014 FOMC meeting (my bold):

But it’s important to point out that the Committee is not anticipating an overshoot of its 2 percent inflation objective (p.13).

Sunday, December 13, 2015

What has the 'monetary arrow' of Abenomics accomplished? To answer this question, recall that this part of Abenomics called for the Bank of Japan (BoJ) to double the monetary base and raise inflation to 2%. On the former goal the BoJ has been successful. On the later goal it is still a work in progress, though inflation has been trending upward.

Assessing the Abenomics inflation record is a bit tricky because the 2014 sales-tax hike in Japan put upward pressure on the inflation rate. Nonetheless, after accounting for the tax hike inflation is overall moving up. This can be seen in the next two figures. The first one shows the core inflation rate since 2000. The second zooms in on the past few years and shows core inflation with and without the tax hike. An upward trend is apparent in this figure. Core inflation is now around 1%, the highest it has been since the late 1990s. So inflation is being pushed up, albeit at a slower paced than originally envisioned under Abenomics.

More generally, Abenomics has been mildly successful at reflating the economy. The figure below shows nominal Japan's NGDP with the Abenomics period highlighted in red. It has risen relatively rapidly.

The figure also highlights NGDP during Japan's QE program of 2001-2006. It was comparatively flat and was supported by what turned out to be a temporary expansion of the monetary base. This suggests that at least some part of the monetary base expansion under Abenomics is expected to be permanent.

So the monetary arrow of Abenomics has been moderately successful at reflating the economy. This reflation, however, has not done much for the real economy. It could do a lot for Japan's debt burden if Abenomics were to continue raising NGDP. And that, in turn, could help reinvigorate the economy. Maybe that is why Prime Minister Shinzo Abe seems so intent on upgrading to Abenomics 2.0.

What is Abenomics 2.0 you ask? It is the Prime Minister's plan to explicitly raise the level of NGDP from its current value of approximately ¥500 trillion up to ¥600 trillion. No, the Prime Minister has not gone all Market Monetarist on us. He is not asking for a growth path target for NGDP, but a one-time 20% increase in the level of nominal spending. Just how ambitious is this goal? Below is a figure plotting out three hypothetical paths to ¥600 trillion NGDP. The five-year path appears to be most in line with Japan's Cabinet Office time frame, as noted by James Cox. By historical standards, this path would be very ambitious for Japan.

"We are aiming to achieve a virtuous cycle of growth and redistribution with our 'Society in Which All Citizens are Dynamically Engaged' plan. This is our proposal for a new socioeconomic system," the Prime Minister told the group.

"We will aim to build a diverse society where anyone can succeed. That will lead to new ideas, which will lead to further growth. Through growth and redistribution, I believe our target of achieving nominal GDP of 600 trillion yen is well within our reach." Japan's current nominal GDP is around at 500 trillion yen.

Abe told the gathering that the government is putting together a 3.5 trillion yen supplementary budget and that he hoped to use around 1 trillion yen of the extra money on his "Dynamic Engagement" project.

[...]

Bank of Japan Gov. Haruhiko Kuroda, speaking at the same forum, gave Abe a vote of confidence, saying the number of "people who say Japan is in deflation has decreased. The bank will continue with its aggressive monetary policy to support corporations' efforts, and, if necessary, will not hesitate in making adjustments."

Delivering multiple speeches on this ¥600 trillion NGDP level target suggests that Prime Minister Shinzo Abe is serious about upgrading Abenomics. It is reminiscent of the fireside chats in the 1930s where FDR was signaling his desire to raise the price level. In both cases leaders were trying to reflate their economies. FDR was partially successfully with reflating, but botched up on the supply side. Prime Minister Abe is trying to get both right with his monetary and structural reform arrows. Here is hoping he succeeds.

P.S. These developments do not bode well for Neo-Fisherism.

Update: Scott Sumner says Abenomics is working even better for the real economy and inflation than I portray in this post. On the latter, he suggests looking to the GDP deflator. It does paint a better picture.

Other observers like Kevin Drum, Jeff Spross, Cullen Roche, and Sudeep Reddy are underwhelmed by Senator Cruz's critique.They acknowledge the Fed should have cut interest rates at its August and September 2008 FOMC meetings, but they question how consequential this inaction was to the Great Recession. After all, the Fed could only cut interest rates from 2% to 0% during this time.

This rather benign assessment of Fed policy in 2008 misses an important point. The Fed's tightening of monetary policy was not just about a failure to cut short-term interest rates from 2% to 0%. It was also about the Fed signalling it would raise interest rates going forwardbecause of inflation concerns. The Fed, in other words, was tightening the expected path of monetary policy during this time.

To see this consider the next two figures. The first one shows the 1-year treasury interest rate minus the 1-month treasury interest rate. Standard interest rate theory tells us that this spread equals the expected average short-term rate over the next year.1 That is, if the spread goes up in value then the market is expecting the short-term treasury rate to rise over the next year and vice versa. This figure shows a sustained surge in the expected short-term interest rate over the next year from April to November 2008. It especially intensifies in the second half of the year. Only in December does the spread really begin to fall. For most of the year, then, the market increasingly expected a tightening of policy going forward.

The second figure shows the 3-month treasury bill interest rate forecast from the Philadelphia Fed's Survey of Professional Forecasters. It compares 1-quarter, 2-quarters, 3-quarters, and 4-quarters ahead forecasts for the second and third quarters of 2008. It clearly shows at every forecast horizon that professional forecasters raised their forecasts of short-term interest rates between the second and third quarter of 2008. They expected more monetary policy tightening in the third quarter 2008.

Again, the Fed tightening in 2008 was not just about the absence of a 2% interest rate cut. It was about an expectation that the Fed was going to raise rates going forward, even though the economy was weakening. This development was huge because current spending decisions are shaped more by the expected path of interest rates than by current interest rates.

So why did the public expect this tightening? Because the Fed was signalling it! Among other places, this signalling was clear in the August and September 2008 FOMC statements. Here is a gem from the August FOMC meeting (my bold):

Although downside risks to growth remain, the upside risks to inflation are also of significant concern to the Committee.

The downside risks to growth and the upside risks to inflation are both of significant concern to the Committee

This was forward guidance at its worst and points to a far more intense tightening cycle than is apparent by looking only at the current policy interest rate. The Fed was willing to strangle the already weak economy over inflation concerns and the market knew it.

It was this severe tightening of monetary policy that turned an otherwise ordinary recession into the Great Recession. As I noted before, this tightening of policy occurred before the worst part of the financial crisis in late 2008. Recall that many of the CDOs and MBS were not subprime, but when the market panicked in late 2008 a liquidity crisis became a solvency crisis for all. Had the Fed not tightened during the second half of 2008 the financial panic probably would have been far less severe and the resulting bankruptcies far fewer. So no, it is not obvious that a severe financial crisis was inevitable.

P.S. The Fed was not the only central bank to tighten in 2008 because of inflation concerns. The ECB did as well and repeated the mistake two times in 2011. These experiences illustrates the the limits of inflation targeting and why it is a monetary regime that has outlived its expiration date.

1Technically, the theory says that long-term interest rates equal the average of short-term interest rates over the same horizon plus a risk premium to hold the longer term security. Since the long-term security here is a 1-year treasury, we are looking at changes in the expected short-term interest rate over the next year. Also, this short-term horizon means the risk premium is small and inconsequential to our story.

Economic historians have made great progress in unraveling the causes of the Great Depression, but not until Scott Sumner came along has anyone explained the multitude of twists and turns the economy took. In The Midas Paradox: Financial Markets, Government Policy Shocks, and the Great Depression, Sumner offers his magnum opus—the first book to comprehensively explain both monetary and non-monetary causes of that cataclysm.

Drawing on financial market data and contemporaneous news stories, Sumner shows that the Great Depression is ultimately a story of incredibly bad policymaking—by central bankers, legislators, and two presidents—especially mistakes related to monetary policy and wage rates. He also shows that macroeconomic thought has long been captive to a false narrative that continues to misguide policymakers in their quixotic quest to promote robust and sustainable economic growth.

The Midas Paradox is a landmark treatise that solves mysteries that have long perplexed economic historians, and corrects misconceptions about the true causes, consequences, and cures of macroeconomic instability. Like Milton Friedman and Anna J. Schwartz’s A Monetary History of the United States, 1867–1960, it is one of those rare books destined to shape all future research on the subject.

Tuesday, December 8, 2015

Imagine we travel back in time to the second quarter of 2009. We stop by the Federal Reserve and reveal to Fed officials that the recession has now bottomed out. They are elated until we disclose that the Great Recession will be followed an anemic recovery for the next seven years. We share how ZIRP, forward guidance, and successive rounds of QE will fail to create an robust recovery and this leaves Fed officials aghast.

Reeling from shock, they ask what they should do instead of these policies. We inform them of the argument for a NGDP level target made by Scott Sumner, Christina Romer, and Michael Woodford. We also inform them that they should signal the seriousness of their intent to do so by making an arrangement with the Treasury Department to back up their actions with contingent 'helicopter drops' should the Fed fail to hit the NGDP level target.

The Fed agrees with our assessment and decides to spend its political capital on the NGDP level target proposal--instead of using it on ZIRP, forward guidance, and QE programs--and gets the backing of Congress and the Treasury Department. The great macroeconomic experiment begins.

So what would happen next in this counterfactual history? How would the economy respond to these combined efforts of monetary and fiscal policy starting in mid-2009? No one can answer these questions with certainty, but it is likely that at a minimum there would be temporarily higher inflation.

The two figures below lend support to this understanding. They come from a paper I am currently working on where I run a counterfactual forecast of inflation starting in mid-2009. The forecasts are based on three different paths of NGDP returning to its pre-crisis trend: a two-year path, a three-year path, and a four-year path.The first figure shows the three NGDP return paths and the second figure shows the inflation forecasts associated with these paths:

Although temporary, inflation is notably higher than both the actual inflation rate that occurred and the 2% target rate under each of the counterfactual NGDP return paths. The inflation rate would get as high as 3.8% for the two-year path and 3.2% for four-year path. Over all counterfactual paths inflation would average around 2.5% since mid-2009, compared to actual average of 1.5%.

These numbers are just counterfactual forecasts, but they demonstrate a key reason why the current monetary regime could never have generated the 'catch-up' aggregate demand growth needed to offset the 2008-2009 crash in nominal spending and return it to its pre-crisis path: it would require higher than 2% inflation for a few years. And that is simply intolerable in the current environment.

The Fed, Congress, and the body politic at large have come to view 2% or less inflation as the norm for advanced economies. Any violation of it--even if temporary and part of a systematic approach like the NGDP level target above--would be viewed as an egregious affront to civilization. Just look at some of the flack former Fed Chair Ben Bernanke got on this issue or the exchange (see last part) between him and former Senator David Vitter on the question of raising the inflation target.

This means that no matter how much QE or forward guidance the Fed engaged in, it would always be done in a way that kept inflation and, as a result, aggregate demand growth in check. This is the Fed's dirty little secret. This understanding also means that no matter how much fiscal policy was done, it too would only be effective up to the 2% inflation threshold. This is the Penske problem with modern macroeconomic policy: it relies on an engine governor rather than cruise control to regulate the speed of the economy. It is time for level targeting.

Thursday, December 3, 2015

Fed Chair Janet Yellen went before the Joint Economic Committee of the U.S. Congress today. She gave her report on the economy and then took questions from members. Probably the most interesting question came from Senator Ted Cruz:

Thank you, Mr. Chairman. Chair Yellen, welcome. In the summer of 2008, responding to rising consumer prices, the Federal Reserve told markets that it was shifting to a tighter monetary policy. This, in turn, set off a scramble for cash, which caused the dollar to soar, asset prices to collapse, and CPI to fall below zero, which set the stage for the financial crisis.

In his recent memoir, former Fed Chairman Ben Bernanke says that, the decision not to ease monetary policy at the September 2008 FOMC meeting was, quote, "In retrospect certainly a mistake."

Do you agree with Chairman Bernanke that the Fed should have eased in September of 2008 or earlier?

This question is interesting because it presents a more subtle understanding of the Great Recession than is found in the standard narrative. In fact, it may be too subtle since it seemed to have caught Janet Yellen off guard. It also seemed to have tripped up the usually sharp Wall Street Journal reporter Sudeep Reddy in his live blogging of the hearing. Both seemed incredulous that Cruz would imply the Fed actually tightened monetary policy in the fall of 2008. But that is exactly what the Fed did, though to see it one has to understand the notion of a passive tightening of monetary policy.

A passive tightening of monetary policy occurs whenever the Fed allows total current dollar spending to fall, either through a fall in the money supply or through an unchecked decrease in money velocity. Such declines are the result of firms and households expecting a worsening economic outlook and, as a result, cutting back on spending. In such settings, the The Fed could respond to and offset such expectation-driven declines in spending by adjusting the expected path of monetary policy. But the Fed chooses not do so and this leads to a passive tightening of monetary policy.

A passive tightening of monetary policy is no less harmful to the economy than an active tightening. The Fed, therefore, should be no less culpable for passive tightening than it is for active tightening. One way to see this is to imagine the Fed as a school crossing guard. If the Fed failed to prevent a child from crossing into a busy street would we be any less indignant than if it instructed the same child to cross into the busy street? Both mistakes are equally dangerous and the result of choices made by the crossing guard. It is no different with monetary policy.

So how does this play into Cruz's comments about 2008? The answer is that the Fed began to passively tighten during the second half of 2008. It had actually done a decent job stabilizing aggregate demand for the two years leading up to this point despite a housing recession occurring during this time. But in mid-2008 it allowed a passive tightening to emerge. Arguably, this passive tightening sowed the seeds for the financial panic that erupted later in 2008 and ultimately is what turned an otherwise ordinary recession into the Great Recession.

Okay, that is story. What evidence do we have for this understanding of the Great Recession?

First, here are two figures that demonstrate the Fed contained the housing recession for roughly two years. They show that employment and personal income outside of housing related sectors actually grew at a stable rate up until about mid-2008. Kudos to the Fed during this time.

But something clearly changes in mid-2008. My argument--echoed by Senator Cruz today--is that the Fed inadvertently allowed a passive tightening of monetary policy. This can be seen in the next few figures.

The first two figures shows the 5-year 'breakeven' or expected inflation rate. It shows that prior to the September 16 FOMC meeting this spread declined from a high of 2.72 percent in early July to 1.23 percent on September 15. This was an unusual sharp decline and was screaming "Trouble ahead!"

One way to interpret this decline is that the bond market was signalling it expected weaker aggregate demand growth in the future and, as a result, lower inflation. Even if part of this decline was driven by a heightened liquidity premium on TIPs the implication is still the same: it indicates an increased demand for highly liquid and safe assets which, in turn, implies less aggregate nominal spending. Either way, the spread was blaring red alert, red alert!

The FOMC allowed these declining expectations to form by failing to signal an offsetting change in the expected path of monetary policy in both its August and September FOMC meetings. The next figure shows where these two meetings fell chronologically during this sharp decline in expectations.

As noted above, this passive tightening in monetary policy implies there would be a decline in the money supply and money velocity occurring during this time. The Macroeconomic Advisers' monthly nominal GDP data (i.e. NGDP = money supply x velocity) indicates this is the case:

The Fed could have cut it policy rate in both meetings and signaled it was committed to a cycle of easing. The key was to change the expected path of monetary policy. That means far more than just changing the federal funds rate. It means committing to keeping the federal funds rate target low for a considerable time and signalling this change clearly and loudly. With this approach, the Fed would have provided a check against the market pessimism that developed at this time. Instead, the Fed did the opposite: it signaled it was highly worried about inflation and that the expected policy path could tighten.

On the financial panic side, note that the Fed kept aggregate demand stable during the early stages of the panic in 2007. Again, job well done. Only in late-2008 after the Fed had allowed passive tightening (as seen by the decline in NGDP) does the financial panic spike. This can be seen in the figure below:

So the worst part of the financial crisis took place after the period of passive Fed tightening. This is very similar to the 1930's Great Depression when the Fed allowed the aggregate demand to collapse first and then the banking system followed.

So it is completely reasonable for Senator Ted Cruz to ask his question today about the Fed's mistake at the September 2008 FOMC meeting. I would only add that this mistake was already in play by that meeting. The September meeting served to confirm the market's worst fear that the Fed was more concerned about inflation than the collapsing economy.

This understanding of the Great Recession is not unique to Senator Ted Cruz, Scott Sumner, or myself. Robert Hetzel of the Richmond Fed has written an entire book that makes this argument (he also has an journal article). So even a Fed insider acknowledges this possibility.

Update: George Selgin shows how the Fed's sterilization in 2008 contributed to the passive tightening of monetary policy.

P.S. This post draws heavily from earlier ones that make the same point. Also see Scott Sumner's arguments for this view: here and here.